Fraud midseason report

My post on the opening of fraud season has received a lot of attention. As a child I used to look forward to hunting season for pheasants in Western Minnesota. Before I was old enough to carry a shotgun I would tag along with my father, and take my slot in the line of hunters who would walk through the cornfields trying to flush out the pheasants. Sometimes the pheasants would take flight in the middle of the field, but most would run along the ground until we reached the end of the field. There they would face the hunters we had sent ahead to wait for their arrival. Not many survived.

Auditing works the same way. While some frauds are found early in the audit hunt, most are flushed out when the annual report deadline approaches and the company faces the auditor. We have seen that at work in Hong Kong where the annual report deadline is rapidly approaching. Annual results must be announced for Hong Kong listed companies by March 31 and the annual reports filed by April 30. Two likely frauds have been outed – Boshiwa and Daqing Dairy. Today, three companies were suspended from trading in Hong Kong when they announced they would not be able to announce annual results on a timely basis. Ports Design said its auditor KPMG would need more time to audit its accounts and that the annual results would not be announced on time and the annual report might not be filed by April 20. Shirble Department Store Holdings (China) Limited was suspended from trading pending an announcement. It had previously said it was delaying its board meeting to approve the annual results by eight days until tomorrow because auditor KPMG needed more time. A lot more time apparently. Ausnutria Dairy Corporation Ltd announced that it would miss its previously scheduled results release date of March 30. There was no indication whether the delay was because auditor Ernst & Young in Changsha, Hunan Province needed more time. There is no evidence yet that any of these situations are frauds.

There may be more delays reported in Hong Kong tomorrow. Then the hunt will shift to New York. U.S. listed Chinese companies must file Form 20F (the equivalent of the Form 10K filed by domestic companies) by April 30. If they cannot meet the deadline, they must file Form NT 20F by April 30 to report the non-timely filing. I predict a sizable number of Form NT 20Fs will be filed this year. Unlike Hong Kong, where companies are suspended from trading upon filing a notice that they will be late, the filing of a Form NT 20F does not automatically lead to the suspension of trading on U.S. exchanges.

In my view, investors ought to consider shorting any company that files a Form NT 20F. I have told this to some auditors, who have squealed in protest. They say there are many reasons why a company might have to delay the filing, and that it is not an indication of fraud. I agree that a late filing does not prove fraud, but I stand by my advice to short.

I believe there are only two explanations for a late filing. First, a late filing indicates that the company is out of control. The annual report is the most important financial reporting task that a company faces. Management knows the deadline well in advance. If management cannot manage to this deadline it speaks volumes about their lack of competence. The second reason for a delay is that the company is fighting with its auditors. Those fights rarely end well for shareholders.

We still have another day in the Hong Kong fraud season, but so far PwC has been skunked. I am sure they are not complaining. In the New York season, I expect more of the problems will be with companies audited by non-Big Four firms. Many of these firms came to market through reverse mergers which have proven more prone to accounting irregularities. Some companies may not file Form NT 20F and just use the occasion to go dark - stop filings altogether.